Interbank counterparty risk and recovery rates in credit default swaps

摘要: In this paper, I measure the interbank counterparty risk embedded in bank credit default swap (CDS) contracts. When a bank writes a CDS contract on the default of another bank, the buyer of that contract is faced with the risk of joint default by both banks. Using a unique feature of CDS data, I present a new approach for valuing CDS spreads that enables identification of the joint and conditional default probabilities, allowing for time variant recovery rates. I use the term structure of CDS spreads and option implied default probabilities to estimate time-variant joint default probabilities and time-variant recovery rates. In comparison to this approach, estimating interbank counterparty risk from CDS spreads assuming a fixed recovery rate underestimates joint default probability when the market is in distress. I apply the joint estimation method to measure interbank counterparty risk of CDS dealers from 2007 to 2010 and find that the fixed recovery rate model underestimates expected counterparty risk by approximately 21% when the market is in distress. In addition, I show that a bank’s vulnerability to systemic risk, defined as the average conditional default probability of a bank conditional on default of its counterparties, is correlated with existing measure of systemic risk.